Beyond a flexible exchange rate policy

It appears our financial markets gurus are still over-fixated with the exchange rate. A recent article, “A flexible exchange rate policy is still right,” starts with the wrong premise but paradoxically concludes and confirms exactly what it was trying to dispute—-exchange rate adjustment is necessary but not sufficient to attracting portfolio inflows and to generating export earnings from diversified non-oil sources on a sustained basis. This is the message we have been conveying for more than a year.

The wrong premise emanates from an attempt to extrapolate and impute arguments about what were never implied: first, by stating that an emerging debate is on-going whether the flexible exchange rate policy was the right thing after-all; and second by noting that an extrapolation of the argument on global capital flows is that “the problem was not with the naira or the fixed exchange-rate policy but a challenge of the global economy at this time.”

Any reasonable economist knows that the world is dynamic and you cannot, given Nigeria’s economic circumstances, simply be fixated with polar extremes of fixed exchange rate and free floating exchange rate regimes. They both have their advantages and drawbacks. With nominal shocks, fixed exchange rate serves you better. With real shocks, free floating serves you better. But neither regime can protect you from foreign financial shocks that affect both domestic goods and financial markets.

Further, when price stability and adjustment to real shocks are both important, there is a need to strike a balance between the fixed and free floating regimes, which are extreme arrangements. Hence, a managed floating system, which is essentially a hybrid flexible exchange rate regime, is preferable to the two polar extreme arrangements. Economics also clearly tells us that whatever exchange rate system that is in place, you cannot run away from the short-run constraints of the monetary policy trilemma or impossible trinity and the triple long-term constraints of the need for a nominal anchor, monetary neutrality and fiscal solvency.

The second premise emanates from the wrong interpretation of the underlying factors responsible for Naira’s exchange rate being the worst among oil exporters. The burden of adjustment has falling relatively heavier on the Naira exchange rate and foreign reserves because Nigeria lacks fiscal buffers due to previous imprudent fiscal pro-cyclicality, which tends to exacerbates economic boom and bust. Nigeria has less than one per cent of its GDP as fiscal buffers compared to more than 50 per cent for several other oil exporters.

Several oil exporters with fiscal buffers in oil savings and sovereign wealth funds (SWF) have used these financial reserves to absorb the initial oil price shock and smooth policy adjustment. Algeria has $200 billion in oil savings that it has been able to draw upon during this oil down cycle and without relying on portfolio inflows.

According to estimates by the SWF Institute, the countries of the Gulf Cooperation Council have a combined total of $2.5 trillion in their sovereign wealth funds and other savings vehicles, which is more than twice the amount of projected budget deficits of $0.9 trillion for 2015-2020. According to the IMF, in countries such as Kazakhstan, Kuwait, Qatar, the United Arab Emirates, and Turkmenistan, the estimated oil savings buffers can finance more than 20–30 years of projected fiscal deficits.

After significant withdrawals of financial savings in 2015, several oil exporters have been tapping into the international debt market because of their higher credit ratings and in spite of their fixed exchange rate regime. Saudi Arabia has proposed $15 billion in international debt issuance. According to Forbes, Oman has raised $1 billion loan and $2.5 billion Eurobond, while Qatar has raised $5.5 billion in the form of a sovereign loan and a $9 billion triple-tranche bond.

Third, Portfolio inflows dance to the tune of global complexities, and usually find the U.S. dollar assets as safe havens during period of uncertainty. This portfolio inflows attribute has been well documented by numerous studies from international organisations including the IMF and the United Nations agencies, by leading economics columnists such as Martin Wolf, chief economics commentator for the Financial Times in his book on Fixing Global Finance.

More recently, as The Economist Magazine has clearly observed, Hélène Rey, of the London Business School, has argued that a country that is open to capital flows and that allows its currency to float does not necessarily enjoy full monetary autonomy as the changes in monetary policy by the U.S. Federal Reserve influence risk appetite of investors, global liquidity and capital flow. As a result, if a country is to retain its monetary-policy autonomy, it must employ additional “macro-prudential” tools, such as selective capital controls or additional bank-capital requirements.

We maintain that in an environment of low oil prices and possible rise in external interest rates, portfolio capital inflows to Nigeria will be lower in the near term than in the recent past in spite of flexible exchange rate. Portfolio flows will pick up once sentiments towards emerging markets improve and global oil prices show signs of rising. We further maintain that in the long run, removing structural impediments to growth and enhancing the business environment and institutional governance would be more crucial to increasing capital flows.

These non-price factors have always blocked the impacts of price adjustment via flexible exchange rate policy from achieving its intended objective. Financial markets analysts have been over-fixated on the exchange rate but are now beginning to wake up to these non-price factors, which they now refer to “additional risk premium factors,” that need to be tackled. We need to move beyond the rhetoric on flexible exchange rate and focus on these other macroeconomic and structural drivers of capital flows, productivity, and sustainable economic growth. It is about time that this message sinks in.

• Dr. Oshikoya, an economist and a chartered banker, is CEO of Nextnomics Advisory.